Why financial markets behave like living organisms

Prevailing economic theory states that financial markets behave in a rational and efficient way, but a new book from MIT Sloan Finance Professor Andrew Lo suggests that the principles of evolutionary biology offer a more complete explanation. After all, a crowd of people making a bank run during an economic panic doesn’t look all that different than a herd of gazelles surrounding the savannah’s lone watering hole.

In Adaptive Markets: Financial Evolution at the Speed of Thought, Lo explains that the financial industry isn’t always rational — as the 2008 financial crisis illustrates all too well — and presents the adaptive markets hypothesis as a way to reconcile the prevailing efficient market hypothesis with behavioral evidence of more irrational human behavior.

What are the limits to the efficient markets hypothesis?

The theory is not wrong, it’s just incomplete. Investors — particularly individual investors without a lot of expertise or time to devote to managing their investments — would do well to focus on no-load, low-turnover investments such as index funds. But this advice has its limitations. Under extraordinary conditions, good or bad, individuals start to make decisions emotionally rather than rationally, which can quickly become counterproductive to wealth accumulation. We need a hypothesis to explain abnormal times, and to build alternatives and other financial models.

Andrew Lo in 2011

Can you briefly describe the adaptive market hypothesis?

Financial markets are more like complex ecosystems, with different species that are competing, evolving, innovating, and adapting. The rules of biology, which govern living organisms, are more relevant for understanding market dynamics than the rules of physics, which govern inanimate objects. The existing paradigm doesn’t capture the full picture — especially the financial crisis and the aftermath.

Economists who have looked at the impact of human behavior on financial performance are in the minority. Why is this the case?

The mainstream economics profession is still devoted to efficient markets and rational expectations for several reasons. First, efficiency and rationality do characterize much of market behavior during normal times, so they play an important role in theory and practice.

Second, economists have developed a tradition and culture patterned after mathematics and physics, where you formulate a well-defined theory and then test it empirically.

Third, mathematical theories are elegant and powerful in that they give sharp predictions of what should be happening. For example, the random walk theory states that tomorrow’s stock returns are statistically independent of today’s returns — this is a very precise prediction. Of course, this theory happens to be precisely wrong in practice.

And finally, it’s harder to apply principles of biology to economics than physics, which is axiomatic. You can derive a lot of theories from a just few simple axioms. In contrast, biology is quite complicated and messy, and requires enormous experimental infrastructure to develop new insights. In order to understand financial markets from an adaptive perspective, we need to change the way we do research. You can’t just write a math formula and run a bunch of regressions to test it. You need to study the flora and fauna of the entire ecosystem. It’s a much more challenging way of doing research, and we aren’t really set up for that. At least not yet.

Why are the principles of evolution so useful for understanding the inner workings of the financial industry?

Financial markets are an adaptation that a particular animal species, Homo sapiens, has developed to improve its chances for survival. We are all better off for having financial markets, as it allows us to fuel economic growth and manage risk. It is, by definition an adaption, so of course the principles of evolution should apply. In contrast to static systems where no adaptation or selection is going on, financial markets are highly innovative and competitive, so we would expect evolution to be able to explain the dynamics of financial markets.

Why is it so difficult for people to be rational about money?

It has to do with the impact of emotion on how humans make decisions. Money and financial markets have only been around for a few thousand years which, on an evolutionary timescale, is a blink of an eye. We’ve adapted supremely well to many other circumstances — our bodies regulate our temperature according to weather and physical activity, and we’ve adapted in many other ways to our environment — but money simply hasn’t been around long enough. We don’t know how to manage our money instinctively.

The adaptive markets hypothesis focuses on the intrinsic human motivations of fear and greed, but fairness and ingenuity also motivate us to act. How can the financial industry facilitate these factors for the greater good?

We sometimes forget that finance is a means to an end, not an end unto itself. Finance doesn’t have to be a zero-sum game if we don’t allow it. We can prevent that from happening by using finance more responsibly, especially for societal priorities. For example, we could issue long-term debt to finance research into cures for cancer, and it would be a drop in the bucket in the 39 trillion dollar U.S. bond market. We can re-engineer the financial system so that it rewards innovation while, at the same time, offering opportunities to reduce poverty and inequality throughout the world. With the right kinds of incentives and financing, and at the right scale, we can do well by doing good. And we can do it now.